CBS.MarketWatch.com

Common misconceptions, he said, are believing that diversification can be achieved adequately through index funds and by scattering money over a broad range of investments.

"We've run into clients [who] come to us with 40 and 50 different fund positions," Donoghue said. "That's ridiculous. You can't even monitor that many, and you're not really getting good diversification."

He tries to remedy such poor exposure with his Donoghue Diversified Sector Portfolio, a market-timing fund that rifle-shoots in and out of industry-specific mutual funds. The objective: "To be in the right investment at the right time, rather than simply spreading your assets over a lot of things."

Performance and philosophy

With assets of $42 million, the fund has beaten the S&P 500 year-to-date as of April 20 by 3 percent -- 5.24 percent vs. 2.03 percent -- with 5 percent less risk. It's also garnered an average three-year total return of 210 percent compared to 97 percent on the S&P.

Donoghue told CBS.MarketWatch.com that it only takes four bull markets -- four high-performing funds at a time -- to make money.

"Our approach has been that there's always a bull market somewhere," Donoghue said. "Basically we're looking at a whole range of individual markets, and all we're trying to do is put together a portfolio of four of these that are growing at the greatest rate in the short term."

Working exclusively with Fidelity funds, the four now making up the portfolio include Fidelity Select Energy Services, Fidelity Real Estate, Fidelity Select Home Finance, and Fidelity Select Financial Services. Candidates close behind on his watch list are Fidelity Hong Kong & China, Fidelity Select Health Care, and Fidelity Select Brokerage. Investment Grade Bond, Cash Reserves, U.S. Government Reserves, and Regional Banks round out the top 10.

Donoghue said he sees his strategy as a middle ground between trading and investing, moving on "intermediate momentum" and seldom holding positions for more than two months. The discipline is reinforced by Fidelity's redemption fees for trades of less than 35 days, he said.

Investing in multiple funds allows for professional expertise without the expense of transaction costs for selling individual securities, Donoghue said. The Diversified Sector Portfolio fee is 1.95 percent and there's a minimum balance of $100,000 for new accounts. Rydex and Invesco offer similar sector funds, he said.

Market timing

Donoghue said market momentum dictates his sector picks. "We're not trying to time the market," he said. "We're letting the market time us."

"When you buy something on momentum you may be buying it just before it declines," he said, crediting the 35-day waiting period with preventing impulse selling. "What it does is, it allows us to have the patience to stick around long enough for something that corrects to rally and get back on its way, and most of the time that's what happens."

While the portfolio now has positions in the financial and real estate sectors, two months ago it was comprised of all technology, he said. "We made a lot of money in technology stocks so we had a much, much bigger cushion when the correction came."

"All that really
happened in the last six months is Santa Claus took back his Christmas presents."
Bill Donoghue

It's a lesson that extends to recent market volatility as well, he said. "If you were in the market when the market was going up, you made a lot of money and you could afford to lose it. If you weren't in the market when the market went up and you got in too late, you lost a lot of money and you didn't have a cushion to make it up from."

"All that really happened in the last six months is Santa Claus took back his Christmas presents."

Unconventional wisdom

Parting company with most financial planners, Donoghue rejects the tenets of modern portfolio theory and asset allocation. Splitting money between growth and value plays doesn't make sense, he said. "Over the last decade, basically any money you had that wasn't in large cap stocks was diluting your return."

He's equally anti-establishment about valuations, saying they've been "wrong for a decade. If you're really worried about valuations, you would not have made much money."

Another pitfall is becoming emotionally attached to pet stocks, he said. "After all, our clients came to us and said, 'Bill, I want you to help me retire rich.' They didn't say, 'I want you to invest in this esoteric security.'"

Donoghue advised against gauging stock market activity by traditional benchmarks like the employment report and other economic indicators. While those figures may have worked in the 80s and early 90s, they don't serve investors well today, he said.

"Frequently you're using out-of-date, soon-to-be-revised government statistics to predict what an Internet-driven stock market's going to do. It's just too out of date."

Overall, a useful strategy is to constantly question the financial environment, he said. "What you have to do in investing is you really have to look at reality and see if your assumptions have changed, and you need to do that every three to five years."

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